Media  International Exchange  2015.01.15

Structural reforms cannot be put off after 2020 Serious risks are accumulated

Weekly Economist published on November 4th 2014

The Chinese economy has gone through alternating cycles of "overheating and stagnation" and "inflation and deflation" in a period of instability in the 20 years since 1992 when China transformed its controlled economy to a market economy. However, since the Xi Jinping government came to power in 2012, China has maintained a steady growth rate of 7% for over 2 and half years.

Recent macroeconomic conditions in China have been stable for the first time since its shift to a free-market economy. Regarding employment, in the first half of this year there was an average of 1.11 jobs for every job-seeker in urban areas, which is the highest level ever. Consumer prices have been healthy: the rate of year-on-year in CPI was 1.6% in September last year; that of cumulative figure from January to September was 2.1%.

The two big engines of the Chinese economy which have powered its rapid economic growth are the progress of "urbanization": promoting migration from rural areas to urban areas, and infrastructure construction. Although, to consider related statistics and infrastructure equipment planning, both of these two engines for Chinese economic growth are likely to slow down around 2020.

When we look at the rate of decrease in the number of agricultural workers, we can predict that urbanization will slow down around the year 2020 at the earliest or in the mid-2020s at the latest. Concerning infrastructure construction, big projects which promote economic growth especially effectively, such as main high-speed express railroads and expressways, will almost all be completed by around the year 2020. Accordingly the effect of infrastructure construction on the economy will gradually decline from this point.

In addition, the decrease in the working population is likely to accelerate after 2020 because of the declining birth rate and aging population. This can be a factor in the slowdown of economic growth. Taking these into consideration, there is a strong possibility that the high levels of economic growth in China will come to an end around 2020 at the earliest and ease into a stable growth period of about 4-5%.

In a period of stable economic growth, it takes longer to recover when economic stagnation is caused by factors such as external shocks than when enjoying high growth. As a result the recession tends to be prolonged. The real concern is the possibility of a prolonged economic stagnation caused by the collapse of a real-estate bubble.

During high growth periods, the risk of a prolonged or serious non-performing-loan crisis is low because real estate prices usually recover to their original level within 1 or 2 years, even after a major fall. However, when an economic bubble bursts during moderate growth, real estate prices continue to drop for a longer period and recovery is more difficult. This is readily apparent from the experiences of Japan in the 1990s or the present situation in western countries from the economic downturn caused by the Lehman Brothers bankruptcy in 2008.

China may also face a risk caused by the decline in industrial competitiveness and export competitiveness.

A requisite for the Chinese economy to maintain high growth is to keep a trade surplus and a stable Yuan. China achieved industrial competitiveness and export competitiveness which in turn enabled China to enjoy a trade surplus and stability of its own currency.

If industrial competitiveness declines, exports fail to grow, the current account balance worsens and the value of currency declines which brings about inflation due to the high cost of imports. To avoid a worsening of the current account balance, there is no option but to adopt tightening macroeconomic policy to restrain domestic demand and slow the rate of growth of imports. However, this can also harm China's growth rate and increase unemployment.

The reform of state-owned enterprises (SOEs) is needed to enhance industrial competitiveness. In Japan, it took a long time to achieve the reform of inefficient SOEs, such as Japan National Railways, Nippon Telegraph and Telephone and Japan Post due to strong resistance by vested interests. Moreover the results, with a few exceptions, were not satisfactory.

The Chinese government still has a strong grip over the country due to the authoritarian nature of the Communist Party. However, an assortment of vested interests has been obstinately resisting reform. Moreover the industrial sector, where SOEs are in the majority, such as steel, shipbuilding, petrochemicals, ceramics, banking, communication and physical distribution industries, make up a bigger share of industry than in Japan. If the reform of SOEs is delayed, the competitiveness of those industries declines.

The problem regarding the inefficiency of SOEs in the period of high growth is not readily apparent because their revenue increases due to the growth in the market size. However, once it falls into a period of stable growth, the performance of SOEs will rapidly decline, and their competitiveness in the industrial field, where they are in the majority, will decline too. The possibility of such phenomena appearing will increase in the 2020s.

In addition to those problems, China may face the political risk particular to its authoritarian regimes that democratic states do not have.

In Japan or western countries, if people are dissatisfied with government policy they can change the government through elections. However, people do not have such a choice in China. Their only option for political change would be to carry out a coup d'état or stage a revolution like those in East European countries or the "Arab Spring."

Of course, if such a thing happened, there would be great disruption to the economy and society of China which would take a long time to recover from. If the government of China, the world's second largest economy, were in disorder the negative impact on the world would be huge. This is especially true with respect to Japan.

Factors which obstruct the structural reforms

Regarding structural reforms, there are many challenges on top of the reform of SOEs.

Issues which cause strong dissatisfaction among the general population are inequality between the rich and the poor and environmental pollution. In order to correct the inequality between the rich and the poor it is necessary to introduce inheritance tax and gift tax which progressively increases and land-holding tax in addition to an increase in the top rate of individual income tax. However, these measures are quite difficult to realise due to strong resistance from the wealthy.

The anti-corruption drive, so-called "striking flies," has achieved considerable success under Xi Jinping's strong leadership, and it is popular among the general population. However, at the same time, in order to obstruct government officials who take a positive attitude toward promoting reforms, instances of vested interests revealing these official's past corruption have been increasing. Also, the number of government officials leaving for the private sector has been increasing due to large cuts in their salaries and benefits. Some have pointed out that the "striking flies" (the anti-corruption campaign) has been having a negative effect on reforms.

In the background of local government corruption there is a fiscal administration system which opaque and inefficient organizations or government officials can easily take advantage of. In order to correct this it is extremely important to rebuild the judicial system which is the fundamental tool of government to correct injustice. However, it is no easy matter to correct corrupt local institutions which have been built up over several thousand years.

On a mid-term or long-term basis, China has to implement an expansion of social security, but this causes an increased financial burden. It would be a challenge to secure a source of revenue in a period of declining growth and fall in tax revenues.

Approaching the point of no return to implement structural reforms

In reality, the necessity of structural reforms was obvious from the Hu Jin-tao and Wen Jiabao government. However, the previous government puts off difficult reforms to seek immediate economic expansion. In the ten years of the previous government the Chinese people's dissatisfaction has grown and trust in the government has shrunk.

The implementation of structural reforms involves painful processes. There is also strong resistance by a group of vested interests. In a high growth period with the resulting increase in tax revenues it is easy to find measures to avoid pain and resistance to structural reforms. However, once growth slows it becomes difficult due to financial constraints. This means that now, in a time of high growth, is the opportunity for China to carry out structural reforms. If the high growth period finishes around the year 2020, it means that Xi Jinping government has only a few years left to do this.

The decisions agreed in the Third Plenary and announced last November took a serious view of the market mechanism and aimed at small government. This was highly regarded around the world. As I see it, Xi Jinping has a positive attitude toward carrying out structural reforms. At the end of July the issue over the corruption of Zhou Yongkang, the ex-Politburo standing committee member, has been more or less settled and the political base of Xi Jinping seems to have increased in stability. It seems like the conditions for the promotion of structural reforms have increased.

However, on the other hand, the movement for reforms seems to be slowing down since the summer. More specifically, in addition to the negative effects of the aforementioned anti-corruption measures there is a possibility that Xi Jinping puts the highest priority on an organizational reform of the People's Liberation Army and does not have the time or strength to promote other reforms even though immediate and bold action is essential.

The role which Japanese companies should carry out is bigger than one may imagine. At present, the expansion of active investment into China supports Chinese high growth through job creation, an increase in tax revenue, and reinforcement of industrial and exporting competitiveness due to a technology transfer. This is why a lot of local governments in China have positive attitude toward welcoming Japanese companies. This situation can earn more time for the implementation of structural reforms and reduce the risks of economic instability during stable growth.

For Japanese companies, it is quite important to win in the Chinese market where the top-ranking companies of the world are competing fiercely for market share. This is because it is no exaggeration to say that a defeat in the Chinese market means a defeat in the global market.

In the Chinese market which is in the most stable condition during the period of high growth but at the same time is holding various future risks, Japanese companies are required to make bold and quick decisions, anticipating both opportunities and risks. If Japanese companies succeed in China, it will increase economic stability in China which will in turn increase business chances for Japanese companies. As long as China has the potential to overtake the USA in terms of GDP by the 2020s, it is fate that China and Japan become inseparably tied together.